Here’s a two-part strategy is incredibly useful for an option trader: Legging an iron condor. This is a tactic we teach in our 1-on-1 Coaching class here at MarketTaker.com.
Legging an Iron Condor
Imagine you have a pretty neutral outlook on a stock, which is trading around $24.85. You feel that this stock might have a little bit higher to go in the near term. The six-month, daily-bar chart shows a slight uptrend. But the RSI is waning, as is ADX. The stock is still trending, but losing steam. There is support around $20. As all my students at MarketTaker.com are trained to do, you would analyze the volatility. In this example, we’ll assume the implied volatility to be a bit high. This set up has all the makings for legging an iron condor.
Again, the stock in this example is trading at about $24.85. You decide to sell a Feb 21-23 put credit spread for $0.55. This gives you some bullish—or, rather not bearish—exposure. If the stock remains above the break even of $22.45 (that’s the short put strike, minus the premium received) by expiration, you’ll have a winner.
The next step—if one was to leg an iron condor—is to sell the call side of the iron condor if the chance materializes (i.e., If the stock continues upward and volatility remains elevated). Let’s explore that possibility. Imagine the stock rises to be trading around $26.25, and you can sell the Feb 28-30 call credit spread for 0.60. This trade would complete the iron condor.
Question: Why not just trade the call credit spread and the put credit spread all at once? Two reasons: Bigger premium and a wider range.
At the onset of this trade, the stock was around $24.85. At that stock price, the 28-30 call spread would have been only around $0.25 bid. It would be a lousy risk-reward to sell this spread for a quarter. The maximum profit potential would be $0.25; the maximum loss potential would be $1.75. You’d need to sell the call spread for more to make it worth it.
But there is an advantage to legging an iron condor: you can only lose on one of the two credit spreads. If the stock rises the call spread can be a loser but, the put spread is sure to be a winner. If the stock drops the put spread becomes a loser but, the call spread profits. Legging an iron condor allows a trader to “double dip”. He or she collects a net premium of $1.15 ($0.55 for the put spread and the $0.60 for the call spread). The maximum profit potential is $1.15, and the maximum loss potential is $0.85.
As we’ve established, with an iron condor the trader can potentially lose on one spread but the other spread, then, must be a winner. But the trader has risk in both directions—up and down. The trader gets paid “double” but has double exposure. How do you manage this? Make the profitable range for the iron condor as wide as possible.
It wouldn’t have made sense to sell the 28-30 call spread for $0.25 at the onset of this trade. You could, however, have sold the 27-29 spread for a reasonable premium. You could have gotten, say, $0.45 if you sold it at the time the put credit spread was traded. But the upside break even would have been tight. It would have been $28.05 (that’s both the call spread premium and the put spread premium, plus the short call strike price).
Legging an iron condor in this case allowed for a better-crafted trade. It offered a high enough premium (the premium for the 28-30 call spread rose as the stock price rose) and a big enough range for the trade to have a reasonable chance for profit.
The risk is that after trading the put credit spread, the stock falls and the chance to put on the call credit spread never comes. Because of this possible outcome, you have to like the first leg, on its own, in order to think about legging an iron condor.